Index derivatives, or stock options?

Today, index futures and index options are traded in India. On 2 July, options on some individual stocks will start trading. What is the role and importance of these two distinct markets?

One major problem that is faced in options trading is the fragmentation of liquidity across many different traded products. For each underlying, such as Nifty, we have 30 to 40 traded options. When options trading starts on 31 stocks, we will have roughly 1000 different options, with distinct prices and order books. There will be a serious shortage of "eyeballs"; a shortage of traders taking interest in each of these 1000 stock options to make them liquid.

Speculators having stock forecasts. The stock forecaster is a person who understands the valuation of one company closely, and has a forecast that one particular company will do well. Traditionally, stock speculators have been forced to implement these views using positions on the stock. For example, a person who believed that TELCO was unusually cheap right now might buy TELCO.

However, this is a highly inefficient implementation of this view. A buy position on TELCO could go wrong for two reasons : the speculator could actually wrong about TELCO, or the overall market index could move against him. Hence, the correct implementation of a optimistic stock forecast is to buy the stock and sell the index futures. Conversely, a speculator who sells TISCO would implement his view by selling TISCO and buying Nifty. These positions accurately express the view of the speculator, and undertake reduced risk.

Stock speculators will find stock options genuinely useful. A speculator on ITC will trade in options on ITC; a speculator on Reliance will trade in options on Reliance. However, by the above reasoning, the Reliance speculator and the ITC speculator will also place orders on the Nifty futures or options, in order to obtain a focused position on the stock of interest. Thus the diffused liquidity across 31 different stock options will yield a focused order flow on the index futures/options market.

Speculators having index forecasts. A great deal of speculation is about the broad market movement. The most common topic of discussion amongst equity investors is always "Where is the market going?". While individual stock trades scroll past on the ticker, the market index is permanently affixed on the screen. Index speculators directly implement their views using the index futures and index options market. The outstanding position on the Nifty futures and options market now adds up to above Rs.100 crore. This reflects the new phenomenon, of investors learning to utilise positions on the index.

The order flow from index speculators will obviously be restricted to index futures and index options. Traditionally, many index speculators in India have imperfectly implemented their index views using a few major liquid stocks. However, there is no need for such imperfect implementations today, now that futures and options on Nifty are available.

Asymmetric information. Speculation on an individual stock is a fairly dangerous affair for most market participants. This is because company insiders always know more than external speculators about the affairs of the company.

In contrast, information about the index is fairly symmetric. Everyone on the market knows roughly the same facts about how the overall economy is faring, political uncertainties, etc. Hence, speculation on the index is a much more attractive game for most traders.

This has one important direct consequence: the bid/offer spread on index derivatives is much tighter than the bid/offer spread on individual stock products. This is, in turn, attractive to day traders who are very sensitive to market impact cost.

Hedgers. The new activity that becomes possible using derivatives, which is not possible using the spot market, is hedging. Individual stock options have no use for hedging: they are only useful for stock speculation. In contrast, index futures and index options have important applications for hedgers seeking to reduce their risk.

One case, mentioned above, is that of the stock picker who has a view about one stock but does not have a view on the overall market. But more importantly, there is the case of the portfolio owner: an investor who is anxious about the movements of his overall portfolio. Every diversified portfolio is dominated by index exposure, so the investor who has a portfolio finds strong benefits by hedging himself against fluctuations in the index. This is done using the index futures or index options.

For example, Nifty is at 1100, and a put option at 1000 is effectively an insurance policy which pays if Nifty falls by worse than 100 points. This is an extremely attractive product for people seeking to protect their overall portfolios.

There is another profound aspect of the order flow from hedgers. When a person has a equity portfolio worth Rs.100, his trades on any one day, engaging in speculation in individual stocks might range from Rs.5 to Rs.25. In other words, on a given day, stock speculation is a marginal activity. In contrast, if a person does engage in hedging, this would generate orders for Rs.100, since the index futures or index options position required to hedge the entire portfolio will prove to be roughly Rs.100.

Hence, once an investor starts utilising the remarkable risk-reductions that derivatives offer, the order size and the trade size that comes into the index derivatives market is much larger as compared with the behaviour we are used to today, which is dominated by stock speculation.

The order flow from hedgers will obviously be restricted to index futures and index options, since stock options are only useful for stock speculation and have no use for hedging.

International experience. The international experience is largely in line with the above arguments. The trading volume on index futures and index options tends to be more than 10 times higher than that of all the individual stock derivatives put together.

In summary. I get asked roughly 20 times a day where the action will be: Will it be in the 33 traded Nifty products, or the 1000 stock options? In my judgement, the dominant liquidity will be found in the 33 traded Nifty products. The trading in 1000 stock options will be too diffused to compete with the liquid Nifty.

There is only one reason to trade in the stock options, while there are so many reasons to trade in the Nifty products. Stock speculation is a hazardous affair, owing to insiders who always know more about the company; index speculation is a fair game with more symmetric information. Once stock speculators think carefully about "free" risk reductions using hedging, speculative orders for each stock will be accompanied by hedging orders on Nifty products. In contrast, speculative orders about Nifty will generate no orders on individual stocks. Finally, portfolio hedging is the new frontier, which will generate huge orders on the Nifty market (only).

Day traders will be attracted by the fine spreads and flickering lights of the 33 Nifty futures and options. The 1000 different traded stock options are unlikely to obtain comparable spreads and activity.

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